Morgan Stanley FX Pulse27 June

Trading the Dollar Rally

When bad is good. Markets have reached the stage where negative US economic news is interpreted as risk positive, and vice versa. This supports our thesis that US economic strength will lead to a wave of USD repatriation, undermining economies reliant on a long period of cheap USD funding. The weak US Q1 GDP revision has therefore provided some market relief, but with US leading indicators coming in on the stronger side of expectations, the current risk rebound is unlikely to last, in our view.
Sterling on its way lower. The US-centric yield increase has not only undermined prospects for the EM asset class, but for Europe too, and in particular, the UK. The UK, confronted by both an ever-rising current account deficit and increasing long-term capital outflows, has seen its basic balance reach a very large minus 15% of GDP; in times of funding cost volatility, we would expect this to put strong downward pressure on GBP. Furthermore, on Monday, ex-BoC Governor Carney will take over from Mervyn King at the helm of the BoE and markets are watchful about whether the leadership change may lead to easier monetary policies. Meanwhile, the UK Treasury has geared its budget policy towards the supply side of the economy, creating initial deflationary effects. Divergence in monetary policy is likely to weigh on GBP/USD.

The EUR bear is back. The US bond yield increase has spilled over into peripheral Europe too. This week’s rhetoric from ECB officials, including President Draghi, has turned dovish as a result of unwanted tighter financial conditions and bond market volatility. While there is justification for the Fed to taper, given the US economy’s resilience, the eurozone is in no position to allow a tightening of its financial conditions via spill-over from external sources. Hence, the ECB might have to step in and cut interest rates imminently, which would catalyze another leg lower in EUR, in our view.